Key takeaways
Paper profits: Enron used mark-to-market accounting to recognise estimated future gains before receiving cash.
Hidden losses: Andrew Fastow’s special-purpose entities concealed losses and liabilities through complex financial structures.
Audit failures: Arthur Andersen helped structure transactions it was subsequently responsible for auditing.
The collapse: Enron filed for bankruptcy in December 2001, triggering a scandal that ultimately destroyed Arthur Andersen.
The jet setter
Ken Lay loved Enron’s fleet of private jets. In total, the conglomerate had two Falcon 900s, three Hawker 800s and a Falcon 50 — but the Lays always flew in the newest Falcon 900, price tag $45 million. Its spacious interior and high-quality wood and leather fittings were much more impressive than the more pedestrian cabins of the other planes.
“It gives my senior people something to aspire to,” Lay once told an ABC News reporter.
The aspirational bar was set very high indeed, because he and his family used the private jets like a personal shuttle: skiing in Aspen, shopping in New York and even sunbathing on the Côte d’Azur.
In summer 1999, for example, Lay’s stepdaughter, Robin, decided she wanted to return to Houston after spending time in Nice. A Falcon 900 was promptly despatched to pick her up — in total, the ride cost Enron’s shareholders $125,000.
The following year, 2000, Lay’s personal plane use cost the company an estimated $334,179.
In an account published by The Guardian in 2002, a pilot who had worked for Enron for several years, and who had lost his job and retirement savings when it declared bankruptcy, described the family’s profligacy.
Ken Lay would book the jet to New York, and so would Mrs Lay, but they would fly separately. Two private jet trips, leaving from the same airport and flying to the same destination, an hour or so apart. The two jets would then fly back empty. This happened eight or more times a year.
While Ken Lay and his family were flying high in 2000, trouble was brewing on the ground.
After years of massaging the numbers, the bill was coming due. Enron’s chief financial officer, Andrew Fastow, was busy creating special-purpose entities to conceal hundreds of millions of dollars in mounting investment losses.
But the roots of the company’s eventual destruction went back much further.
Profits before the cash arrived
In 1990, Enron recruited Jeffrey K. Skilling from McKinsey to develop a newly established gas trading business.
Skilling was ambitious, confident and determined to transform Enron from a conventional energy business into a sophisticated trading operation.
Central to his plans was the adoption of mark-to-market accounting (MTM), rather than the traditional accounting methods Enron had used previously.
This was a consequential decision.
Mark-to-market accounting allows companies to value certain assets, liabilities and contracts at their current estimated market value, recognising changes in those values in their financial statements.
When applied to long-term energy trading contracts, it also enabled Enron to recognise the estimated present value of future net profits when a contract was signed, rather than waiting for those profits to materialise over the contract’s lifetime.
This meant that Enron could report substantial accounting gains before the underlying contracts had generated cash.
For contracts traded in liquid markets, fair value could be established using observable market prices. However, many of Enron’s longer-term and more complex contracts had no readily available market price.
Instead, their values depended on financial models incorporating assumptions about future energy prices, demand, interest rates and other economic variables.
The result was financial statements that increasingly reflected management’s projections of what might happen in the future, rather than profits already realised.
And those projections could be remarkably optimistic.
All managers needed to do to generate higher reported profits was increase the estimated value of a contract or asset, provided they could persuade the accountants and auditors that their assumptions were reasonable.
The incentives were powerful.
Bonuses for employees involved in developing and selling contracts could be based on the profits recognised when the deals were signed. Managers could therefore be rewarded long before the anticipated cash flows materialised — assuming, of course, the projects were even successful, which in many cases they were not.
The practice created an additional problem. Because profits from long-term contracts were recognised up front, Enron constantly needed new deals to generate further earnings growth.
It was a system that depended on an apparently endless supply of profitable transactions.
The SEC gives its blessing — with conditions
To shift to mark-to-market accounting, Enron sought approval from the US Securities and Exchange Commission (SEC).
Arthur Andersen helped the company make its case, providing a letter supporting the proposed treatment for its natural gas trading business.
The application was not approved without scrutiny. SEC officials questioned Enron’s proposed valuation methods, its accounting assumptions and the reliability of the estimates underlying the contracts.
On January 30, 1992, the SEC issued a no-objection letter permitting Enron Gas Services to adopt mark-to-market accounting, subject to conditions intended to ensure that contract valuations were objective and independently verifiable.
The regulator’s letter contemplated adoption from the beginning of 1992.
Skilling was ecstatic. He gathered his team in a conference room on the 31st floor of Enron’s headquarters and brought out champagne to celebrate. By mid-afternoon, around 50 employees had reportedly joined the festivities.
Enron subsequently informed the SEC that it had decided to apply the method from the beginning of 1991 instead, claiming that the financial effect was not material. The SEC apparently did not respond further.
In subsequent years, Enron expanded the use of mark-to-market accounting into other trading activities.
There was nothing inherently improper about fair-value accounting. Applied correctly, it can provide investors with more relevant information about the current value of assets and liabilities.
The problem was that Enron’s accounting increasingly depended on assumptions that were difficult to verify, while management had powerful incentives to produce favourable results.
The SEC had made clear that valuations needed to be objectively supportable.
But the detailed work of testing those valuations fell largely to the company’s auditors.
And Arthur Andersen continued signing off Enron’s financial statements year after year.
Enter the Raptors
Of course, there is only so long a company can get away with inflating its profits and camouflaging the gaps between unrealistic assumptions and harsh realities.
By the late 1990s, Enron was accumulating significant losses on investments whose values had fallen below the amounts recorded in its accounts.
Recognising those losses would have damaged the company’s reported earnings and potentially undermined investor confidence.
Andrew Fastow had a solution.
He created a network of special-purpose entities (SPEs) — separate companies established for specific transactions that, under the accounting rules then in force, could sometimes remain outside the parent company’s consolidated financial statements if they satisfied certain independence and financing requirements.
The problem was that many of Enron’s SPEs were anything but independent.
In 1999, Enron’s board approved arrangements allowing Fastow to manage and invest in partnerships known as LJM and LJM2, despite the obvious conflict of interest involved in the company’s chief financial officer controlling entities that would transact with Enron.
The partnerships purchased assets from Enron and participated in transactions supposedly designed to protect the company against investment losses.
Some transactions allowed Enron to remove poorly performing assets from its balance sheet or recognise gains from sales to supposedly independent buyers.
But if the buyer was effectively controlled by Enron’s own chief financial officer, and Enron continued bearing the underlying economic risks, how genuine were these transactions?
The arrangements were also extraordinarily lucrative for Fastow and his associates.
Enron’s subsequent internal investigation found that Fastow had received at least $30 million from his participation in the partnerships, while other employees had earned millions more.
Enter Raptor I in April 2000, followed by three additional Raptor structures over the following months.
These were elaborate financial vehicles ostensibly designed to hedge Enron’s investments against declines in value.
A genuine hedge transfers financial risk to another party. If the value of an investment falls, the counterparty compensates the company for some or all of the loss.
But Enron’s Raptors were financed principally through Enron’s own shares or arrangements involving those shares.
In other words, Enron was effectively trying to insure its investments against losses using its own capital as the principal source of protection.
If Enron’s investments fell in value while its share price also declined, the entities would be unable to honour their obligations.
The arrangement defied basic economic logic.
Nevertheless, the accounting manoeuvres produced spectacular results.
According to the special investigation commissioned by Enron’s board after the collapse, the company recognised approximately $500 million in revenues from derivative transactions with the Raptors during the second half of 2000, generating $532 million in pre-tax earnings, including net interest income.
Those earnings accounted for more than 80% of Enron’s reported pre-tax profits for the period.
The Raptors had become central to the company’s apparent financial success.
But the profits were built on structures that had not genuinely transferred the underlying risks away from Enron.
The auditors knew about the structures
Arthur Andersen was not simply an outside observer encountering Enron’s accounting decisions after they had been made.
The firm participated in structuring the Raptor transactions and advising on their accounting treatment, charging more than $1 million for those services.
The subsequent investigation commissioned by Enron’s board concluded that Andersen had failed to provide the objective accounting judgement that should have prevented the transactions from proceeding.
There had also been warnings from within Andersen itself.
Carl Bass, a technical specialist in the firm’s Professional Standards Group, repeatedly challenged accounting treatments approved by the Enron audit team.
Between 1999 and 2001, Bass raised concerns about transactions that he believed violated established accounting rules.
His objections created tension with David Duncan, the Arthur Andersen partner responsible for the Enron audit.
Enron complained about Bass, and Andersen’s senior leadership eventually removed him from the engagement.
Their judgement may have been influenced by the commercial importance of the client.
In 2000 alone, Enron paid Andersen $52 million in fees: $25 million for audit work and a further $27 million for consulting and other services.
Enron had become a client that Arthur Andersen could scarcely afford to lose.
The relationship had also become extraordinarily close. Andersen auditors occupied offices inside Enron’s Houston headquarters, employees moved between the two organisations, and the audit team had become deeply embedded in the client’s business.
The boundaries between auditor and client had become dangerously blurred.
That relationship, and the subsequent destruction of audit documents as Enron unravelled, would ultimately lead to the collapse of Arthur Andersen, bringing an end to one of the world’s largest accounting firms.
The numbers unravel
By early 2001, the financial structures that had enabled Enron to avoid recognising investment losses were beginning to fail.
As the value of the investments declined, the Raptors needed increasing amounts of financial support.
But the value of Enron’s own shares — on which the structures depended — was also falling.
The very instruments intended to protect Enron against investment losses were themselves becoming increasingly worthless.
Rather than recognise the losses immediately, management attempted to restructure the vehicles.
In March 2001, Enron transferred additional arrangements involving hundreds of millions of dollars of its own stock to support the Raptors, allowing it to defer the recognition of substantial losses.
But these manoeuvres could not continue indefinitely.
In August 2001, Sherron Watkins, an Enron employee and former Andersen accountant, wrote to Ken Lay warning about the company’s aggressive accounting practices.
She identified the Raptors as a particular source of concern, questioning whether they had concealed investment losses and whether the company’s financial statements could withstand scrutiny.
Watkins feared that Enron could implode in a wave of accounting scandals.
Her warning proved prescient, as her subsequent testimony before the US Senate would make clear.
In September, the Raptor arrangements were terminated.
On October 16, 2001, Enron announced a $1.01 billion after-tax charge relating to several businesses and investments, including $544 million associated with the termination of transactions involving the LJM partnerships.
The company also disclosed a reduction of approximately $1.2 billion in shareholders’ equity.
What was left unsaid was the fact that this enormous reduction in equity was not merely a side effect of terminating deals. It reflected serious accounting errors that had artificially inflated Enron’s balance sheet in previous periods.
The genie was out of the bottle.
As investors, analysts and regulators began examining the company’s financial statements more closely, the complex structures that had sustained Enron’s reported performance became increasingly difficult to defend.
On December 2, 2001, Enron filed for bankruptcy.
One of America’s most admired corporations had collapsed, leaving shareholders, employees and creditors facing enormous losses.
Arthur Andersen, whose auditors had approved Enron’s financial statements and participated in structuring some of the transactions, would not survive the fallout.
Its subsequent destruction transformed the Big Five accounting firms into the Big Four.
The business of manufacturing profits
Enron’s collapse was not the result of one accounting trick or one dishonest executive.
It was the culmination of years of aggressive financial reporting, increasingly complex transactions and a corporate culture in which meeting earnings expectations appeared to matter more than the underlying economic performance of the business.
Mark-to-market accounting had enabled the company to recognise profits before receiving the cash. Its special-purpose entities allowed management to conceal losses and liabilities that would otherwise have damaged reported results.
And when the investments underpinning those transactions began to lose value, the company manufactured financial structures intended to make those losses disappear.
The executives who designed and approved these arrangements were rewarded handsomely, while the shareholders whose capital was ultimately at risk remained largely unaware of what was happening.
But perhaps the most troubling aspect of the scandal was the failure of the institutions responsible for holding Enron to account.
The board approved arrangements involving obvious conflicts of interest. The auditors participated in structuring transactions whose accounting treatment they were then expected to assess independently. And regulators relied heavily on those same auditors to verify management’s increasingly subjective valuations.
In September 1998, SEC chairman Arthur Levitt had warned about corporate managers, auditors and analysts participating in a game in which the desire to meet earnings expectations could override faithful financial reporting.
Enron demonstrated how destructive that game could become.
By the time the financial engineering stopped working, the company’s reported profits had become so disconnected from its economic reality that there was no way to repair the damage.
The accounting had concealed the losses. It had not made them disappear.
Recommended reading
Arthur Andersen and Enron: How a Big Five Accounting Firm Collapsed
How Andersen’s relationship with Enron, its failure to challenge questionable accounting and the subsequent destruction of audit documents led to the firm’s demise.
How the Big Eight Audit Firms Became the Big Four
The mergers and scandals that reshaped the accounting profession, culminating in Arthur Andersen’s collapse in 2002.
McKesson & Robbins: The Fraud That Changed How Audits Are Done
How an elaborate accounting fraud in 1938 escaped detection by Price Waterhouse and transformed auditing standards.
Explore the scandals, regulatory changes and historical events that shaped Deloitte, PwC, EY and KPMG.
Explore more Big Four history
This article is part of the Big Four History series, tracing the firms, mergers, scandals and regulatory changes that shaped Deloitte, PwC, EY and KPMG.
Explore the full Big Four History hub →
About Claudine Cassar
I’m a corporate anthropologist and former Deloitte equity partner. I sold my technology business to Deloitte in 2016 and led the Malta Consulting team for five years. I am the founder and editor of Big4News, which provides independent, clear analysis of PwC, Deloitte, EY, and KPMG — free from corporate spin.
Find me on LinkedIn, X, Instagram, or my author website.
Feel free to reply to this newsletter — I read every reply.